Posts pertinent to the entrepreneurial economy. From 2016 onward, focused more on private securities offering exemptions and topics related to startup and emerging company financing.

13 posts categorized "November 2009"

By http://profile.typepad.com/1237764140s22740 //
November 29, 2009
in Angels

I've stayed out of the on-again, off-again debate about how Seattle entrepreneurs compare to their counterparts in Silicon Valley. I can't seem to wrap my mind around a discussion that might require me to imagine my home of Seattle as a province. Not sure why. Perhaps it's that I've raised kids here, know and admire entrepreneurs here, have gotten to appreciate the light here. It might also have something to do with childhood memories of San Francisco, from a time that city was down on its luck; or the fact that Seattle has been in constant ascendancy economically, technologically, culturally, philanthropically, since I moved here in 1991.

In any event, I'm provoked now to speak, having read something on TechCrunch this evening, something I know for a fact to be false:

"Even a city like Seattle, which had two colossal wins in Microsoft and
Amazon doesn’t see a critical mass of angel activity—or even venture
activity according to Dow Jones VentureSource. Typically just under one
hundred startups raise venture capital in the entire state of
Washington each year. For all the talk that Boston’s venture scene is
'dead,' Massachusetts still gets nearly three times as many deals.

Italics added to identify the falsehood; I'll go ahead and allow that the rest of the quote may be accurate enough. The quote is from a piece by Sarah Lacy and it is from an otherwise interesting article, about the gap between angel and VC financing in India.

There are active, passionate angels investing in Seattle, and from where I sit, they back companies further into their growth than was typical in the 90s. In the web and IT spaces in particular, angels can end up providing companies with all the investment capital they need to generate revenue. What's more, here in the Noughties, as compared to the 90s, Seattle startups are as likely to be founded by execs and engineers in mid-career as they are by twenty- and thirty-somethings; this means the field of angels is broadening (and also why it is so important to nip Senator Dodd's misguided "reforms" of the accredited investor threshold and of Reg D primacy in the bud) as these execs and engineers bring both their own money and those of their peers into the ecosystem.

The misconception may arise in part from the tendency of many privately-financed startups to stay off the radar. I think that characteristic is changing, however, and will continue to change. Access to financing will always be important and will always be an issue of interest; it's also good for our region to have active and viable venture capital firms. But we are in an era where the financiers need entrepreneurs as much as or more than the latter need the former, and that is a good place to be. We can call this place, "Seattle."

I watched (via the archived webcast), with great interest, your opening statement from the Nov. 19 Banking Committee markup hearing on the financial regulatory reform bill. You, sir, appear to be unique among the Senators on the committee in your sensitivity to how the bill might impact entrepreneurs and the financing of startup companies in our country.

I am writing to urge you to look at Sections 412 and 928 of the bill. Section 412 could, potentially, knock many active angel investors out of the startup financing ecosystem. Section 928 would end federal preemption of state regulation of Reg D "accredited investor" offerings, greatly increasing the costs of raising capital, and making certain seed investing unfeasible (particularly when funding sources are spread across two or more states).

These two provisions are aggressive and are hostile to, as you put it so well, "the engineer graduating from Virginia Tech with an idea for a startup" who needs to “find access to capital and grow that startup and develop the next transformative technology."

I am an attorney in Washington State, where I work with entrepreneurs, startup companies and angel investors. A number of us in our state have written a letter to Senators Murray and Cantwell, asking them also to look into this matter. I am appealing to you because, given your background as a venture capitalist, and the sensitivity of your remarks in the hearing last week, I am hopeful that you will quickly appreciate how damaging these small provisions in the “Restoring American Financial Stability Act of 2009" would be to startup companies.

More information on our efforts in Washington State can be accessed in this post to a prominent Seattle startup community blog: http://www.seattle20.com/blog/Entrepreneurs-Investors-Lawyers-Ask-Senators-to-Protect-Startup-Financings.aspx.

Thank you very much,

William Carletonhttp://wac6.com

A template for sending email to Senator Warner can be found here. A petition to support federal preemption of states over Reg D offerings can be found here.

Also, I've added a "Reg D" tag to this blog, to make it easier to find my posts on this subject. If you are new to this issue, the best summary is still the guest post Joe Wallin and I wrote for Seattle 2.0.

The
Senate Banking Committee has had an initial hearing to consider Senator Dodd's
“Restoring American Financial Stability Act of 2009.” Initial statements by
members of the committee are posted
on the committee's site. I skimmed them, looking for additional insight as to
what is driving
proposals, buried within Senator Dodd's bill, that would hurt
the ability of startups to raise seed financing.

I
didn't find much. That makes sense, because the themes of Dodd's bill are
really, really big, and the two provisions that would directly harm startups
(check that, the two we've managed to discover) are relatively small. What's
more, legislators who might otherwise be sensitive to impacts on tech ventures
may have the general impression that all must be well, since the
venture capital industry has announced satisfaction with VC exemption from
private fund adviser registration requirements in a
key House bill (an exemption Dodd's
bill only broadens).

I
did, however, find this in the written statement of Senator Mark Warner of
Virginia:

"We
need to fix our capital markets so that the engineer graduating from Virginia
Tech with an idea for a startup can find access to capital and grow that
startup and develop the next transformative technology."

That
prompted me to find Senator Warner's opening statement on the
archived webcast of the hearing. What follows below is my transcript of
excerpts from Senator Warner's delivery at the hearing, taken from between
minutes 375 and 378 of the recording. I think all readers of my blog will find
these quotes interesting.

"I
think one of the things we need to recognize is that, you know, over the last
few years, banking and investment banking have been the place to be, as year
after year we've seen banks record record profits. But I think that we've seen
that many of those gains were really based upon black magic. And that the magic
of the marketplace has turned into a nightmare for an awful lot of families and
businesses and in many ways for the country. To a degree, it's time to make
banking a little bit more boring again. . . ."

"I think that we have exacerbated over the last decade an enormous shift -
that we already had in our tax code, but that's been greatly enhanced - of debt
over equity. We've seen leverage ratios at unprecedented levels, we've seen
folks who through financial engineering create instruments of financial
destruction. I made my living as a venture capitalist, and, you know, a lot of
bright people used to go into starting up jobs, starting up companies. But why
would you go start up a company in today's world where you have to put equity
at work and take all the risk of actually creating something, when you can use,
you know, obscenely high leverage ratios and go out and create a financial
engineering tool that might create you
a lot of wealth, but really doesn't add a lot of innovation, jobs or value to
our overall society. So I come to this committee as someone, or perhaps
somebody from this side of the aisle who will match his free market credentials
with anybody on the committee or for that matter in the Senate. And as much as
I believe in the market, though, I also believe that the market's got to have some
rules of the road, and that that's what our challenge is going forward. . .
."

"I know that there are tremendous numbers of businesses, entrepreneurs and
others who are waiting on the sidelines, waiting for us to get a new set of
rules. Because the existing financial regulatory system, they've just lost
faith in. They don't want us to overdo, but they also, I've not met anyone,
even from the financial industry, that hasn't acknowledged that there was
excess and there needs to be correction. And I think that the only way that we
can return to where we get that balance right, where people are once again
innovating, creating jobs and value, is to make sure we've got an appropriate
set of financial rules, rules of the road."

From
these comments, and even from Senator Warner's tweet
reporting on the hearing, it's apparent the Senator sees a big picture, feels
that appropriate financial regulatory reform, broadly speaking, can be a means
to restoring
the primacy of value-creation over financial machination. I may sound
parochial on this, but, here in Seattle, we've never suffered from a diversion
of ambitious people to financial and banking careers; we've always found
finance boring, and believed that committing to a startup is to set out for the
summit of Maslow's
hierarchy. But in the interest of keeping it possible to raise seed money
to start new ventures, we sure could use a financial reform bill that doesn't
lump in (afterthought?) provisions that would (a) drum
many angels out of the ecosystem and (b) make it wholly unfeasible to
include out-of-state residents in seed financings.

The
call to save Reg D started
in Washington State, has gone national with an online petition and Facebook
group, and will (hopefully) garner discussion on additional startup and
venture industry related blogs across the country. I will send Senator Warner
an email; but those of us who feel strongly about this might ask Virginians
we know to call on their junior Senator. It would be great if Senator Warner
could have a peek at the few lines in the bill that would have an incredibly
negative impact on the entrepreneurs he rightfully extols in his opening
remarks.

Joe Wallin, Brian Myers and I have put up a petition concerning the threat to Reg D, an issue about which all three of us have written in recent days (for background, see this post published yesterday by Marcelo Calbucci on Seattle 2.0).

The platform for the petition permits signers to add comments. Here are excerpts from three:

Kyle Flindt of Washington: "Shall we do away with the Uniform Commercial Code too? I
am a patent attorney and I work in the technology industry with
entrepreneurs. Entrepreneurs are the Weapons of Mass Reconstruction
that our economy needs right now."

Thomas Monaghan of Massachusetts: "The
system works. Please do not break it for the entrepreneurs who are the
key to pulling our great nation out of this recession!"

Matthew Smith of Idaho: "Startups are vital to a sustainable recovery."

Best I can tell, the fact that Senator Dodd would let states impose their own standards on Reg D offerings is just now getting out there. See this post by VC Jason Mendelson, indicating that there is now awareness of the issue outside Washington State. Some big law firms have whitepapers that cover Dodd's gigantic draft legislation in impressive detail - see for example ones from K&L Gates and DLA Piper - but those I'm finding still don't flag the repeal of federal preemption.

I'll come back to that question below. Let me first report on what's happened in the week since Joe Wallin discovered that Senator Dodd, Chairman of the Senate Banking Committee, has proposed to k.o. federal preemption of state regulation of Reg D offerings.

Earlier today, a letter was mailed to the senior and junior U. S. Senators for the State of Washington, Senator Murray and Senator Cantwell, objecting to the proposal, and asking the Senators to save Reg D, for the sake of startup companies in Washington and throughout the country. Senator Dodd's proposal would make it much more difficult and potentially unfeasible for startups to raise modest amounts of seed financing, particularly when their angel investors might reside in two or more states. The letter was signed by 24 entrepreneurs, investors and attorneys who reside in Washington State, including Joe and me.

The gist of the Reg D issue and the potential implications for startups are summarized best in a guest post that Joe and I co-authored and that Marcelo Calbucci published today on Seattle 2.0. Joe's and my post for Seattle 2.0 has the benefit, too, of the perspective of Keith Baldwin, a partner of Joe's who has thirty years experience, and who can compare the current Reg D paradigm against the era when state regulators were not preempted from adding their own requirements to offerings that already met Reg D standards.

Reaction from those in the startup community that Joe and I have talked to over the past week has been unanimous: federal preemption works, is safe, and lets entrepreneurs put the proceeds of seed financings to productive uses, rather than lawyers' fees.

A number of people, however, have asked the same, perceptive question: if nothing is broken with Reg D, why would Senator Dodd propose this change?

Why would Dodd want to gut Reg D?

Which brings me back to my first question, slightly rephrased: How did we live before Google?

In a quiet minute this past weekend, I typed the following query into the Google searchbox: "state securities regulators ask congress to end federal preemption." I had no actual knowledge that any had; just a supposition that, if anyone was going to have a reason to want the clock turned back on federal preemption, it would be a state securities regulator.

Bingo.

The top return for my query was entirely relevant and timely: a Sept. 15, 2009 speech by the new President of the North American Securities Administrators Association, Texas Securities Commissioner Denise Voigt Crawford. Here's an excerpt (emphasis added):

The
areas of state law preemption often mirror the types of fraud and abuse
inflicted on investors. This is not a coincidence. Without question,
the most harmful area of state securities preemption has been
Regulation D offerings. Since they also enjoy an exemption from
registration under federal securities law, Reg D offerings receive
virtually no regulatory pre-screening at any level of government. Only
enforcement actions are brought and they are rare.

As a result
of short-sighted state law preemption, investors have been exposed to
far more risk in private placement offerings than Congress likely could
have imagined. Investors deserve better than this. At a minimum,
Congress should reinstate state regulatory oversight of all Rule 506
offerings.

And there you have it. Things are either much different in Texas, or some people just really see the same world differently.

I've been practicing in Washington since 1991, and, while I am thinking about it really, really hard, I have yet to think of a single instance where an investor has been harmed by a private offering being legitimately exempted from registration by Reg D. We're not talking about fraud or other circumstances giving rise to criminal or civil lawsuits here. Instances of fraud do occur. But state regulators are not preempted from bringing enforcement actions with respect to fraud or deceit (see 15 U.S.C. 77r(c)(1)). And nothing about Reg D exempts companies from complying with the antifraud prohibitions of federal securities laws.

To be fair to Commissioner Crawford of Texas, restoring state regulatory oversight to Reg D offerings under Rule 506, and Rule 506 only, would, by implication, still permit startups to raise smaller sums under Rule 505. But the move to de-federalize Reg D-type offerings is troubling.

Even within the four corners of the federal rule, with his call to make it tougher to satisfy the accredited investor standard (discussed earlier on this blog here), Senator Dodd would make it harder for startups to raise money from legitimate angel investors. (There isn't the same consensus in the community about the accredited investor standard as there is on federal preemption over Reg D, however. Some in the community feel an increase in the net worth and/or annual income tests might be appropriate, though no one I know thinks it should match the rate of inflation since 1982, when the current thresholds were set.)

But back to the titular question of this post: I think the answer may be that Senator Dodd is responding to advocacy from states or state regulators.

No need for me repeat Venkat's analysis. But I do want to relate one or two things in the new Twitter privacy policy back to a prior concern of this blog, the ownership of Tweets.

Under the heading "Information Sharing and Disclosure," Twitter's new privacy policy adds the following new sentence: "Non-Private or
Non-Personal Information: We may share or disclose your non-private,
aggregated or otherwise non-personal information, such as your public Tweets or
the number of users who clicked on a particular link (even if only one did)."

Let's be clear: very little of what the Twitter user does on Twitter carries with it any expectation of privacy. Sure, you can choose not to share your tweets except to those who receive your permission to follow you -- but then you might as well confine yourself to the suburbs, er, I mean, Facebook. As Venkat points out in his post, geo-location information is something Twitter now lets you turn on or turn off ("geolocation is opt-in and this makes sense"), so it may be that additional variegation in control will follow with proliferation of functionality.

Let's be even clearer: we don't want privacy, not with our tweets. Twitter knows this and it knows we know this, so the company reminds us of this in the privacy policy: "Most of the information you provide to us is information you are asking
us to make public." But notice an interesting elision here: Twitter states it is being asked to publicize, not simply your tweets, but, more broadly, "the information you provide to us." Paraphrasing the new policy, the kind of information you are "asking" Twitter to make public includes, in addition to your tweets, the following:

the metadata provided with your tweets (such as time of tweeting;

the lists you create;

the people you follow;

the tweets you favorite;

the tweets you retweet;

and "many other bits of information."

The metadata and "many other bits of information" associated with tweeting are what Scobleizer and others think will help Twitter adopt a business model around advertising (something I worry will look too much like online publishing, selling short the vision of an ad-less world).

In my last post on this subject, I wrote:

Social media and the phenomenon of user generated content may be
creating a new kind of ownership, one under which an author can control
certain artistic and moral rights in her work, but not certain
derivatives, and not information that is derived or aggregated from the
work.

Twitter's new privacy policy follows that direction, I think, making more it overt, too, that Twitter and its business partners may exploit tweets and metadata for commercial purposes. I hope Twitter, or a successor platform of comparable ubiquity, will still be hospitable for those pursuing a vision of an ad-less web.

Reference Note: below is a blackline of the "Information Sharing and Disclosure" section of Twitter's privacy policy, tracking changes from the old version to the new.

Information Sharing and Disclosure

Tip:
We do not disclose your private information except in the limited circumstances
described here.

Your Consent: We may share or
disclose your information with your consent, such as when you use a third party
web client to access your Twitter account.

Service Providers: We engage certain trusted third
parties to perform functions and provide services to us, including,
without limitation, hosting and maintenance, customer relationship, database
storage and management, and direct marketing campaigns..
We willmay
share your personally identifiable information with these
third parties, but only to the extent necessary to perform these functions and
provide such services, and only pursuant to binding
contractual obligations requiring such
third parties to maintain the mirroring the
protections of this privacy and security of
your data.policy.

Compliance with
Laws Law and Law Enforcement Twitter
cooperates with government and law enforcement officials or private parties to
enforce and comply with the law.Harm: We may disclose any
your information about you to
government or law enforcement officials or private parties as if
we, in our sole discretion, believe that
it is reasonably necessary or appropriate to
respond to claims, to comply with a
law, regulation or legal process (including
subpoenas),request; to protect the property
and rights of Twitter or a third party, the safety of the
public or any person, to prevent or
stop any illegal, unethical, or legally actionable activity, or to comply with
the law.; to address fraud, security or technical issues;
or to protect Twitter's rights or property.

Business Transfers Twitter may sell,
transfer or otherwise share some or all of its assets, including your
personally identifiable information, in connection with a merger, acquisition,
reorganization or sale of assets or in the event of bankruptcy. You will have
the opportunity to opt out of any such transfer if the new entity's planned
processing of your information differs materially from that set forth in this
Privacy Policy.

Business
Transfers: In the event that Twitter is involved in a
bankruptcy, merger, acquisition, reorganization or sale of assets, your
information may be sold or transferred as part of that transaction. The promises
in this privacy policy will apply to your information as transferred to the new
entity.

Non-Private or
Non-Personal Information: We may share or disclose your non-private,
aggregated or otherwise non-personal information, such as your public Tweets or
the number of users who clicked on a particular link (even if only one did).

Under current law, a startup or emerging company (or any issuer of securities) that is able to meet an exemption under Reg D isn't going to have to worry about state regulators imposing their own substantive standards on a private financing. States may (and do) impose fees and require copies of a standard form to be filed when their residents are purchasers in a Reg D offering, and states retain jurisdiction to bring enforcement actions for fraud or deceit; but startups and emerging companies raising private money today focus on finding investors who are accredited and on otherwise meeting the federal Reg D requirements, not on state securities laws.

What would it mean, were this aspect of Dodd's bill to become law? Potentially, it
could mean that securities regulators of various states might impose
inconsistent standards for exemptions from state registration
requirements. If this happens, then, as Joe points out in his comment, legal fees for companies raising money would increase.

Some states may feel that the bar set by Reg D is too low, and that investors in their jurisdictions may need further protection than what they receive under federal law. See for example this historical letter to the SEC from the Massachusetts Securities Division, which expresses a decidedly investor-protective point of view: "In our regulatory experience, it is possible for an individual to meet [the $1,000,000] net worth threshold [to qualify as an 'accredited investor'], and nonetheless be an unsophisticated
investor who would benefit from the protections provided by
registration or exemption under state law."

That's the gist of this post. For kicks, I'll include below some discussion of the mechanics of the legislative language. I don't know about the big themes of Dodd's bill (the creation of new regulatory agencies), but the provisions pertaining to Reg D are not good.

________________________________

Here are the nine lines in question from the Dodd bill:

SEC. 928. RESTORING THE AUTHORITY OF STATE REGULATORS OVER REGULATION D OFFERINGS.

Section 18(b)(4) of the Securities Act of 1933 (15 U.S.C. 77r(b)(4)) is amended--

The to-be-stricken "subparagraph (D)" functions as one of several definitions of the term "covered security" under Section 18(b) of the Securities Act. The definition "covered security" is in turn pertinent because of Section 18(a) of the Securities Act, which preempts state regulation of "covered securities." Specifically, Section 18(a) states in pertinent part that "no law, rule, regulation, or order, or other administrative action of any State or any political subdivision thereofrequiring . . . registration or qualification of
securities transactions, shall directly or indirectly apply to a
security that
is a covered security" (clause numbers and letters removed for readability).